Theory of Cost

1. From Short Run Total Product

curve to Short Run Total Cost
2. Seven Cost Curves
3. Long Run Cost Curve
• 759 Store is a local grocery
store selling low price
imported products
(snacks). The first outlet
opened in 2010.
• By 2015, the number of its
outlets exceeded 280, close
to that of ParknShop and
Wellcome (about 300
each).
 • In 2017, Store 759
recorded a loss of
HK$29.5 million.
• Online stores like Ztore,
HKTVmall joined the
market, eroding 759’s
advantage.

• Before, Store 759 gains bargaining power by boosting its

scale. The strategy fails in recent years.
• What are the factors that causes store 759 to suffer loss?

Source: Can snack food retailer 759 Store

overcome the crisis? EJ insight. 1st August 2017
 1. From Short Run Total Product curve to
Short Run Total Cost
Name Short Form Calculation
• Types of Costs Total Cost TC TC = TFC + TVC
– Short-Run Total Fixed TFC rK
Cost
• Fixed costs (TFC) Total Variable TVC wL where L is
• Sunk costs Cost variable
• Short-run variable Average Cost ATC TC/Q
Average Fixed AFC TFC/Q
costs (TVC) Cost
• Short-run total costs Average AVC TVC/Q
(TC) Variable Cost
Marginal Cost MC dTC/dQ =
– Long-Run dTVC/dQ
• All costs are variable
• No fixed costs
Deriving the short run total cost curve from total
product curve
TP = Q

Q3

Q2

Q1
TVC L
wL3 wL2 wL1 L1 L2 L3
When wage increase, TVC rotates
upward
TVC

Q
 2. Seven Cost Curves
TC = C(Q) = TVC(Q) + TFC $
TC = C(Q) = TVC + TFC
TVC(Q): Costs that vary
with output. VC(Q)
TFC: Costs that do not vary
with output.

TFC

0 Q
 Fixed Costs
TFC: Costs that do not $
change as output changes. C(Q) = TVC + TFC

TVC(Q)

TFC

Q
 Some Definitions
Average Total Cost
ATC = AVC + AFC $
MC ATC
ATC = C(Q)/Q AVC

Average Variable Cost

AVC = TVC(Q)/Q
MR
Average Fixed Cost
AFC = TFC/Q

Marginal Cost AFC

MC = dTC/dQ
Q
 Fixed Cost
MC
$
Q(ATC-AVC) ATC
= Q AFC
= Q(TFC/ Q) AVC
= TFC

ATC
AFC Fixed Cost
AVC

Q Q
 Variable Cost
QAVC MC
$
ATC
= Q[TVC/ Q]
AVC
= TVC

AVC
Variable Cost Minimum of AVC

Q Q
 Total Cost
QATC
= Q[TC/ Q] MC
$
= TC ATC
AVC

ATC

Minimum of ATC
Total Cost

Q Q
1) The above table gives some of the costs of the Total
Delicious Pie Company. What is the total fixed cost of Output variable Total
producing 100 pies? (pies) cost cost
A) $300
(dollars) (dollars)
B) $400
C) $700
D) More information is needed to calculate the total
fixed cost. 0 0 300
100 400  
2) The above table gives some of the costs of the
Delicious Pie Company. What is the average variable 200 1,000  
cost of producing 300 pies?
A) $1,800
300 1,800  
B) $6 400 2,800  
C) $5
D) More information is needed to calculate the
average variable cost.
3) The above table gives some of the costs of the Delicious Pie Company. The
marginal cost of increasing pie output from 200 to 300 pies equals ____ per pie.
A) $1.800
B) $1,000
C) $8
D) $6

4) Ernie’s Earmuffs produces 200 earmuffs per year at a total cost of $2,000 and $400
of this cost is fixed. What is Ernie’s marginal cost per earmuff if he increases production
to 220 earmuffs, his total cost increases to $2100, and his fixed cost remains $400?
A) $105
B) $35
C) $9.55
D) $5
5) Based on the above figure, at which level of
output does diminishing marginal returns first
occur at Ike’s Ice Cream Kitchen?
A) At 0 gallons.
B) At 10 gallons.
C) At 40 gallons.
D) At 60 gallons.

6) As illustrated in the above figure, after 60

gallons are produced each hour at Ike’s Ice Cream
Kitchen, the ATC curve starts to slope upward. The
ATC starts to slope upward when
A) the MC curve slopes upward.
B) the MC exceeds the ATC.
C) the distance between the ATC and the AVC
curve is shrinking.
D) None of the above answers is correct.
 Exercise

Marginal Average Marginal

Workers Output Total Cost
Product Total Cost Cost

0 0
1 20
2 50
3 90
4 120
5 140
6 150
7 155
a) Now fill in the column for marginal cost. What pattern do you see?
b) Fill in the column of marginal products. What pattern do you see? How might you
explain it?
c) A worker costs $100 a day, and the firm has fixed costs of $200. Use this
information to fill in the column for total cost.
d) Fill in the column for average total cost. What pattern do you see?
e) Compare the column for marginal product and the column for marginal cost.
Explain the relationship.
f) Compare the column for average total cost and the column for marginal cost.
Explain the relationship.
 McDonald – 24/7
• What is the reason that McDonald chooses to
open 24 hours a day, 7 days a week?
1000

900

800 TC
700

600

500

400

300

200

100

0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170
25

20

15
A
C
10

0
0 20 40 60 80 100 120 140 160 180

45
40
35
30
25 M
20 P

15
10
5
0
1 2 3 4 5 6 7
 3. Long-Run Average Costs

LRAC

Economies Diseconomies
of Scale of Scale
Q* Q
COST

LAC
SAC1

0 Q
q0
 Building a larger sized plant (size
2) will result in a lower average
COST cost of producing q0

LAC
SAC1

SAC2

0 Q
q0
 Likewise, a larger sized plant
COST (size 3) will result to a lower
average cost of producing q1

SAC1 LAC
SAC2
SAC3

0 Q
q0 q1
COST

LAC

SAC1

SAC2

Economies of Diseconomies of Scale

Scale
0 Q1 Q

LONG-RUN AVERAGE COST CURVE

 Economies and Diseconomies of Scale

• Economies of Scale- long run average cost

decreases as output increases.
– Technological factors
– Specialization

• Diseconomies of Scale: - long run average cost

increases as output increases.
– Problems with management – becomes costly,
unwieldy
Q1. In the long run,
A) all resources are fixed.
B) at least one resource is fixed.
C) all resources are variable.
D) there are no variable costs.

Q2. In the figure, between 20 and 25 units

per hour, the firm experiences
A) economies of scale.
B) diseconomies of scale.
C) constant returns to scale.
D) increasing total fixed costs.
Q3. A firm is operating in its range of economies of scale and is on
both its LRAC curve and its short-run ATC curve. At that level of
output, the slope of its LRAC curve is
A) zero and the slope of its ATC curve is zero.
B) zero and the slope of its ATC curve is negative.
C) negative and the slope of its ATC curve is zero.
D) negative and the slope of its ATC curve is negative.
Q4. Which of the following statements about average costs is
incorrect?
A) The difference between average total cost and average variable cost
does not change as output increases
B) Average variable cost first decreases and then increases as output
increase
C) Average fixed cost decreases as output increases
D) Average total cost first decreases and then increases as output
increases
E) The difference between average total cost and average variable cost
is average fixed cost
 Store 759 in 2017
• Shop rental expense still was the largest component in the
cost structure … a rise of 3.3% increase.
• The value of total retail sales declining for 20 consecutive
months, the level of shop rent still stayed high.
• As the revenue decreased … the rent-to-revenue ratio climbed
to 13.4% (2015: 11.3%).
• The average wage of frontline staff increased for about 7.8%
when compared with that of last year.

• Now, can you tell why store 759

suffers loss in recent years?

From Interim Report 16/17

CEC International Holdings Limited
 Store 759 in 2020
• The Group’s revenue recorded HK$1.08billion (2019: HK$0.9
billion), increasing for 19.8% as compared to last year (2019).
The profit increased from HK$5 million to HK$14 million
(196% increase).
• … the growth of demand during the period mainly came from
the products of staple food categories…
• The Group operated 173 stores (in 2019: 177) with a decrease
of 4 stores in the total number of stores.
• … the labour cost of frontline staff was increased by 9.6% as
compared with last year (2019).
• … the selling and distribution expenses of the retail business
dropped decrease of 2.0%, as the Group focused on cost
control during the period.
From Interim Report 20/21
CEC International Holdings Limited